Two Economies Geared For Inflation… In a World of Deflation

Courtesy of Janet Yellen hinting that maybe, possibly, there might be an interest rate rise next month — and the EU tax man chasing Apple for US$18 billion — the Dow has retreated a little from its recent highs.

The All Ords has also surrendered some of its recent gains, in part due to the potential US rate rise, but also due to weaker earnings resulting in lower dividend payouts.

Investors have been conditioned to believe the Fed has their backs. So no one seems to be overly worried by the recent volatility. It’s this complacency that’s likely to drive another assault at a new high before this whole charade is exposed.

In this world of relative peace and tranquillity, gold has lost its recent gloss…down to US$1,311 per ounce.

The mere hint of US rates rising has taken the Aussie dollar down a notch or two. The RBA and exporters will be happy.

All in all, the world is in ‘wait and see’ mode.

But, away from the day to day noise of the markets, there are much bigger trends at play.

Trends that mean tomorrow will definitely not be a repeat of yesterday.

Earlier this month, the ABS released the latest employment numbers. Our unemployment rate fell to 5.7%.

But, as always, the statistics do not tell the whole story.

Here’s an ABC headline:

‘Unemployment drops to 5.7pc but part-time work hits record high: ABS data’

The majority of jobs are being created in the part-time sector.

This should come as no surprise…it is part of the deflationary world we’ve been talking about.

In a world where competitive pressures are squeezing margins and industrial relations legislation makes it difficult to shed labour without triggering significant penalties, businesses are understandably reluctant to employ people on a permanent basis.

Employment appears to be transitioning from security to insecurity.

Household income is gradually becoming more reliant on part-time and/or contract positions.

The Millennial generation faces a future of lower wage growth, lower rates of marriage, lower birth rates, and higher asset prices, while being saddled with higher student debts. What a contrast to the situation baby boomers found themselves in 30 or 40 years ago.

The change in generational starting positions is why the past era of economic growth is unlikely to be replicated anytime soon.

This is a very slow, and low growth, world.

Lower economic growth adds to the deflationary spiral, which in turn creates the environment that produces a low cost, flexible workforce. The cycle feeds off itself.

The lack of job security doesn’t create the confidence needed to perpetuate the baby boomer credit binge of yesteryear.

All you need is enough people — not everyone — to exercise spending restraint and the debt-dependent economic growth engine starts to cough and splutter.

Which is why deflationary pressures are being felt in all major economies.

Changes in Australian Employment

According to the article, ‘Despite24-years of sustained economic growth,’ we now have a new class of low-wage work.

Hello! The world has not stayed still over the past 24 years.

There’s been an awful lot of change in the global economy.

Debt levels are much higher. Developing economies have advanced at quite a pace — bringing with them hundreds of millions of skilled and unskilled workers on much lower pay rates. Automation is ramping up. Complacency has meant Australians (or at least enough Aussies) genuinely believe this is the ‘lucky country’ — immune from major economic shocks.

In confirmation of the trend towards more part-time employment, The Australian article noted:

‘Employers use a myriad of means to reduce labour costs. Whether it is hiring more juniors, casuals, part-timers, trainees or migrants on short-term visas, the drive to remain competitive through cheaper and more flexible labour hire can be seen throughout the economy.’

While the private sector is feeling the harsh winds of deflation, it’s a different story in the public sector.

On the front page of The Weekend Australian, dated 20 August 2016, the headline read: ‘Jobs surge at expense of taxpayers’. The article continues:

‘Rampant growth in public-sector wages is exacerbating the nation’s debt and deficit woes and stoking concerns among business leaders about continued government borrowing to pay wages bills.’

Public sector wage growth was around 2.4% compared to just 0.4% in the retail sector. Gone are the days of the lowly paid, high security public service job. These days it’s a case of: highly paid, even higher security, and much less service to the public.

The parasitic public sector — which relies on tax revenues and/or increased levels of government debt to pay higher wages — is outgrowing its host. Clearly, not a sustainable situation.

If the private sector host is feeling the effects of deflation, then it is only a matter of time before the impact is felt in the public sector.

Government, at some stage (either voluntarily or involuntarily), must trim costs — wages, entitlements, and healthcare. This also feeds into the deflationary spiral and fosters a more sombre social mood. Hardly the right mindset for a spending splurge.

In the US, the slowdown in the private sector is impacting tax revenues. This is an extract from a report by Nick Colas of Convergex:

‘Looking at individual tax/withholding receipts (available from the U.S. Treasury) for the month of July [2016], there is a reason for caution on both indicators. July “Withheld” receipts — those tax and withholding payments that come straight from wage earner pay stubs — are down 1.0% year over year. Also worth noting: YTD non-withheld tax receipts (such as those that come from ‘Gig economy’ workers) are down 6.5%, and July’s comp is 15% lower than a year ago. Last, corporate tax receipts are down 11% YTD, and if the current pace of these payments holds it will be the first negative comp since 2011. Bottom line: if the tax man isn’t as busy, can the U.S. economy really be expanding?’

For the record, the ‘Gig economy’ is industry speak for ‘part-time workers’.

While the statisticians can manipulate the employment numbers, the taxes paid by real workers and real businesses cannot be so easily fudged.

Falling tax receipts is an indicator the employment and corporate earnings situation is not as upbeat as the statisticians and analysts make it out to be.

The downturn in US earnings raises serious questions about the longer term capacity to service corporate debt levels.

The tighter the deflationary vice squeezes earnings, the greater the likelihood of corporate defaults.

Charles Gave, of highly respected GaveKal Research, recently released a paper titled: ‘Irving Fisher, Debt-Deflation and the Bifurcated US Economy’.

Gave’s analysis divided the US economy into two parts — goods production and services.

Gave suspects the US goods producing sector (due to its debt load) is more vulnerable to an earnings downturn than the services sector. To quote:

‘Now, I do not know how much of the US corporate debt pile has been issued by services-producing companies and how much by goods’ producers. However, it is safe to say that industrial companies are more capital intensive than service providers. As a result, goods’ producers generally have more debt than service sector companies, which almost by construction tend to be cash flow positive. The logical conclusion, although I cannot prove it, is that the debt issued by goods-producing companies is much larger than their share of the value added in the system.’

The debt-laden US goods-producing sector, like our manufacturing sector, faces relentless cost pressures from lower cost Asian producers. To keep it from going under, it means costs — including wages and staffing numbers — will be cut AND, where possible, automation introduced. This, too, feeds into the deflationary outlook.

Not all goods-producing businesses will survive. Those with the moist debt will fall first…triggering a wave of corporate defaults.

Eventually, the pain being felt in the goods-producing sector must domino onto the services sector.

Gave ponders whether the Fed may wake up to the looming deflationary problem in the goods-producing sector and start buying corporate bonds to avoid a wave of defaults…as the European Central Bank (ECB) is doing.

But can the Fed buy all the corporate debt? No.

So who owns this debt? Banks, pension funds, and individuals.

Investors — institutions and individuals — who chased yields are going to take a haircut.

Impoverished investors feed into the deflationary spiral.

Gave arrived at this conclusion:

‘…the present situation is clear: the world’s industrial system is in deflation, and could move into Fisherian debt-deflation at any time. If that happens, it would be surprising if it had no impact on the service economy.’

At present we have an economy functioning at variable speeds. The pace depends on whether you’re in private or public (and goods-producing or services) sectors of the economy.

Private sector goods production is the driver of economic growth. The services sector and public service all feed off a productive, growing economy.

At present, we have two economies operating at different speeds, but, in the end, we have one world and it is deflating.

This is a world we are not prepared for. We have, literally, geared up for inflation…a continuation of a past trend.

The trend has changed. It is moving towards deflation and, as difficult as it is to contemplate, you have to act contrary to how we’ve been conditioned. You pay down debt, increase cash levels (yes, even in this low rate environment)…you put the credit card on ice and live within your means.

Cheers,

Vern Gowdie,For Markets and Money

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Vern Gowdie has been involved in financial planning since 1986.
In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.
His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia.
He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback.
His contrarian views often place him at odds with the financial planning profession.
Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction.
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